Lewis turning point and China's FDI prospects

Recent labor market developments in China have drawn media attention to the rising labor cost in China. More than 50 years ago, Arthur Lewis pointed out that with the expansion of the modern sector of a low-income country, the “unlimited labor supply” (from the rural sector’s labor surplus) would disappear and as a result the country will enter into a phase of faster real wage increase.

Many countries including South Korea and Japan have experienced such a change. What about China—is it already at the Lewis turning point? Is this the end of a cheap labor manufacturing era for China? If it’s true, what would be the impact of the new labor cost dynamics on the country’s economic growth pattern and on the world (for example, on global imbalances)?

Real wage of the manufacturing industry and foreign funded unites of China

Source: China statistic year books, China National statistic bureau

The coming of the Lewis turning point for China has been noticed since 2004, when the “shortage of labor” was first faced by manufacturers in the southern coastal area. Rising labor cost has already impacted some aspects of the economy. For example: net FDI flows to China in 2009 plummeted by 64% to $34.3 billion. A closer look at the credit and debit sides of the FDI inflows of the Balance of Payment table shows that the net decline was from both the credit side, where new foreign investment in China declined by 32% to $110 billion from the historic high of $147 billion in 2008, and the debit side, a 143% increase of disinvestment from the country (see figures). Besides large capital withdrawals from financial sectors, non-financial sectors saw disinvestment of $21.2 billion, up 64% from 2008.

China FDI inflow: investment and disinvestment

Source: China State Administration of Foreign Exchange

Although the fall in China’s FDI last year was largely due to the liquidity problems of international investors after the subprime crisis, the Lewis turning point discussion also questions how the increasing labor cost will change the prospects for FDI flows to China. Will the disinvestment from China in the next couple of years increase due to the possible shift of manufacturing from China to countries with even lower wage costs such as Vietnam? Will there be a shift of FDI from manufacturing to other sectors of China?

It is clear that China’s manufacturing sector has seen a decline in its share of FDI since 2005, with the infrastructure and finance sectors gaining larger shares of FDI.

China FDI inflow to manufacturing industry

Source: China statistic year books. NBS

But several factors may slow down the tide of disinvestment in China’s manufacturing sector in the next few years. First, the increase of labor supply from rural areas into the manufacturing sector has not been exhausted, due to the fact that there are still large real income gaps and between rural and urban area in China (1: 3.3 as of 2009. Source: Green book of China rural economy 2008-2009, China Academy of Social Science). Second, the manufacturing shift may happen within China where labor costs can be lowered by moving away from the coastal areas. Third, the shift may push up labor costs of other economies as well due to the large scale of the factories. (Then we may see another wave of automation in the industry). Fourth, moving production across countries will incur large costs. The labor cost in China has to rise to a certain threshold to trigger large disinvestment. Small factories or low value-added manufactures may move first.

So is this change good or bad?

The change is in line with the current economic development strategy of the government which is to shift from export-reliant growth to a more sustainable growth driven by domestic demand. It may also benefit the global rebalance. However, as with any other changes, there will be pain and risk. The main concern here is inflation pressure, domestically, and even globally.

Comments

Increase in Chinese labor cost may, of course, hurt the market for low-value manufacturing production (and related FDI). In fact, according to a recent survey among 1600 German manufacturing firms, 20 percent said that they are planning to pull out from China due to cost-consideration. This said rising wage rates are supporting the appeal for China for market-seeking FDI. In 2009, more new cars were sold in China than in US, a fact that attracts foreign car manufacturers. So at the end, it is the composition rather than the value of FDI that might be changing. In addition, moving towards higher value-added manufacturing FDI has been part of the Chinese government's FDI strategy for the last few years.
Dilek Aykut

Dilek: Thanks for your comments and good example. And also thanks for your valuable advice and discussions which initiated this post.
Yes, the trend of sector structure change of FDI flows to China in the near future is pretty clear. I am wondering whether the survey shows the destination of the shift of the investment. Will the withdrawal investments stay in the home countries or shift to other developing countries that have lower labor cost.
I just landed China and will feel the Change here.
Yueqing

I have noticed you publish an index of the level of Industrial production in China. I was wondering if I could kindly ask you the source or how is obtained or better if data is available.
Regards,
David